A BAYESIAN APPROACH TO OPTIMAL CROSS-HEDGING OF COTTONSEED PRODUCTS USING SOYBEAN COMPLEX FUTURES

Cottonseed crushers face substantial risk in terms of input and output price variability and they are limited in their planning by the lack of viable futures markets for cottonseed or cottonseed products. This study examines the feasibility of cross-hedging cottonseed products using soybean complex futures. Bayesian tests for market efficiency are performed on the cash and futures prices. The test results reject the presence of nonstationary roots, leading to the conclusion that the markets are not efficient. Different cross-hedging strategies are designed and analyzed for eight different hedging horizons in order to maximize the expected profit and utility of the crusher. A Bayesian approach is employed to estimate the parameters, which is consistent with expected utility maximization in the presence of estimation risk. The investigation reveals that both whole cottonseed and cottonseed products can be successfully cross-hedged using soybean complex futures. The profitability of cross-hedging cottonseed products depends not only on the appropriate size of the contract but also on the optimal choice of strategy consistent with the time of placing and lifting hedge and the appropriate hedging horizon.